Over-the-counter

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The over-the-counter (OTC) derivatives market refers to a marketplace that is conducted off-exchange. These derivatives are privately negotiated between two parties, compared to listed derivatives traded through an established exchange or other intermediary.

The most commonly traded OTC derivatives are swaps, forward rate agreements, and exotic options. The market in OTC derivatives is much larger than that in exchange-traded derivatives, and it is unregulated. These derivatives are also vulnerable to counterparty risk, because the validity of a contract depends on the counterparty's ability to honor its obligations, rather than using an exchange clearing house as the guarantor.

Decentralized trade is carried out over the telephone, electronically or over a fax machine. Dealers carry inventories of product and facilitate the buy and sell orders of market participants.

According to the Bank for International Settlements, the total outstanding notional value of over-the-counter derivatives stood at $516 trillion as of June 2007.[1] This figure rose to $700 trillion by November 2011.[2]

OTC credit derivatives have been blamed in part for the 2008 financial crisis. It is said that these allowed banks to think they were cutting risks when in fact they were just being hidden in a web of private trades. U.S. Treasury Secretary Tim Geithner was quoted in British Mail Online on May 16, 2009, saying that he wanted most OTC derivatives trading to move to being traded through exchanges.[3]

OTC Derivatives and the Dodd-Frank Act

In July 2010, President Barack Obama signed into law the Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). Several provisions of the 2300-page law relate to over-the-counter derivatives, including:

On April 29, 2011, the U.S. Department of the Treasury issued a proposed determination on FX swaps and forwards, essentially exempting OTC forex from its definition of swaps.[5]

On July 19, 2011, the CFTC issued its final rule on the review of swaps for mandatory clearing, which outlined the process by which derivatives clearing organizations (DCOs) may clear OTC swaps.[6]

On Oct. 18, 2011, the CFTC approved its first set of final Dodd-Frank rules regarding [[derivatives clearing organizations. These rules, which become effective January 9, 2012, cover such topics as core principles, risk management, financial resources and clearing and processing requirements.[7] For more information, see the DCO regulation page on MarketsReformWiki.

Larry Tabb - TABB Group [INTERVIEW]

Larry Tabb is the founder and CEO of TABB Group, an advisory and research firm focusing on issues surrounding financial markets. His research and publication topics include trading and trade processing systems, market structure, regulatory issues, and technology trends. He is a contributing editor for Wall Street & Technology and Advanced Trading magazines, and is a frequent speaker at major business and industry conferences. Former John Lothian News editor-at-large Doug Ashburn spoke with Tabb about the future of OTC derivatives, capital and margin requirements. Published November 9, 2011. For more video, visit JohnLothianNews.com.

References

  1. "Triennial and semiannual surveys on positions in global over-the-counter (OTC) derivatives markets at end-June 2007," 11/21/08. Bank for International Settlements.
  2. Total Outstanding Notional Value of OTC Derivatives Tops $700 Trillion (BIS, 6/30/2011). DistressedVolatility.com.
  3. LSE could win in shake-up of derivatives. Mail Online.
  4. KPMG - Regulation of the Over-the-Counter Derivatives Market. KPMG.
  5. US Treasury grants exemption for forex swaps. FT.com.
  6. Open Meeting on Three Final Rule Proposals and Two Proposed Rules under the Dodd-Frank Act. CFTC.
  7. Open Meeting on Two Final Rules and One Proposed Amendment. CFTC.